Small-cap stocks aren't always flavour of the month, and their performance can sometimes deter investors. However, handled within a balanced portfolio approach, they can be important sources of return, so advocates say. We talk to London-headquartered Oberon Investments.

WealthBriefing recently sat down with Richard Penny, fund manager, Oberon Investments, a UK-based firm, and Simon McGivern, CEO at the business. We examined the performance characteristics of small-cap stocks and how they should be addressed within portfolios. 

Penny joined Oberon Investments after leaving CRUX Asset Management. Before CRUX, he spent 15 years at Legal & General Investment Management, where he managed the L&G UK Alpha Trust and L&G UK Special Situations Trust. He also previously worked at M&G Investment Management and Scottish Amicable Investment Management.

WealthBriefing began by asking Penny about the performance of small caps.

Penny: What's important to understand about small cap out performance is that through the cycle, they outperform by 2.5 per cent per annum in most developed world markets. Small caps are usually defined as the bottom 10 per cent of markets by market capitalisation. If you focus on micro caps, which tend to represent the bottom 2 per cent by market capitalisation, they outperform by 4 per cent per annum. There are very few free lunches in active management, but this looks like one. But where it's not quite a free lunch is that they're cyclical, as smaller companies tend to be more oriented to the economic cycle. So, they will underperform the market in a downturn and significantly outperform in an economic recovery. They're also subject to quite marked swings in sentiment, which in some ways can be more predictable than trying to forecast the economy.

WB: Can you illustrate about the case for buying “unloved” firms and how this works, including understanding behavioural cycles in the small-cap space?
Penny: As just mentioned, small companies outperform long term but are cyclical. This graph very much shows the cycle. We've got three complete cycles from the .com bubble, to the global financial crisis (GFC) and then COVID 19, followed by a really pronounced downswing since September 2021 which we absolutely believe, sets us up for a significant recovery. 

If you can go through a period of three and a half years, as we've just seen, which is unprecedented, and get that out of the way, then it should lead to a very significant short-term recovery. Now, in terms of understanding how it works, the UK small-cap market (AIM) is currently down 48 per cent, and 30 per cent of the AIM market, (which is 200 companies), are down 80 per cent which is nearly 100 per cent underperformance against the FTSE 100. 

Even more significant, when you factor in that the FTSE100 is very cheap currently. So, if there are 200 stocks underperforming by that much, this is a fantastic opportunity to be a selective stock picker. You're not going to buy all of them because many of them are distressed beyond repair, but historically, we have made incredibly good returns in this kind of market.

WB: What sort of recovery potential do you see in UK small-caps vs the blue-chip sector, etc.?
Penny: We fully participated in those gains that have been seen in recovery phases such as post GFC and Covid 19. To the extent that the declines since September 2021 have been twice as bad as in the GFC on a relative basis, and it's gone on for three and a half years, which is way longer than it normally is. We think that there will be a very significant recovery for us. This is why we are excited, because in 2008 to 2009 we delivered 171 per cent outperformance. By being a recovery buyer of growth companies in Covid 19, we made 150 per cent gain slightly less, but over a shorter period of time.

So, what would we predict? We would certainly predict double-digit returns for UK equities from here. But if you can leverage this small-cap opportunity by selective stock picking, we certainly hope to double the funds in a three-year period and potentially more. 

In terms of what we might expect going forward, I think given the level of the UK market in general, the FTSE suggests that we should get double-digit returns. That's suggested by long-term indicators such as the cyclically adjusted price/earnings (CAPE) but given the significant underperformance of the small-cap market, and these kinds of supercharged returns that we do get in recovery, one would expect a premium to that. 

WB: How much of an issue is the liquidity of small-caps and how do you manage it?
Penny: The liquidity of small caps has been an issue and arguably the driving factor behind why they are so cheap now. That said, we've seen outflows in the UK market, and when that reverses, the liquidity will work in a positive direction. From an Oberon perspective, we manage market liquidity by having different funds. The funds are all relatively small because we are a boutique investor. This is an advantage, as we can get significant amounts of the fund assets into these smaller more interesting stocks but not be too big relative to the market. With our bigger funds, such as TM Oberon Special Situations Fund, we have a select number of large-cap companies that are liquid, and some mid-cap companies in the £2 to £6 billion range, which would be 50 to 60 per cent of the fund. And that makes the fund very liquid. So, our special situations fund only has 30 to 40 per cent in the small-cap end, and is effectively a very liquid play on this small-cap cycle.

WB: Where in the UK market do you see particular small-cap opportunities and what is less inviting?
Penny: Bearing in mind what we've just said, we are a selective stock picker, so we're not here to defend the totality of the market. It has gone down on average 48 per cent since 21 September, and there are about 30 per cent of stocks down 80 per cent, and some of those are extremely interesting, though we would only be covering up to say 10 per cent of those names. 

We are selective stock pickers, but I would say the sub £200 million ($269.9 million) area is interesting, because that's where you have a real chance of getting far more than you're paying for. 

WB: Who in the field of small-cap investing do you admire, either in the UK or overseas, and as a source of inspiration?
Penny: At home in the UK I’m definitely an admirer of Giles Hargreaves, who's been very good at managing special sits and small-cap funds, and he's done it from a boutique style and built a sizeable business. We'd love to emulate him. He's a great investor. Then in terms of more globally, perhaps surprisingly, I'm a big admirer of Howard Marks who is a contrarian debt investor, but the way he explains the economic cycle and how behavioral investing works around it, is very appealing to somebody who, at their heart, is a contrarian investor, as we are.

WB: Where in your view should, depending on a risk profile, should small-cap investing of the type you do sit in a wealth client’s portfolio, and why?
Penny: So, I would have thought that small caps, on a global basis, should be 2 to 10 per cent of equity portfolios. I think at this point in the cycle, you might want to be at the higher end of that, because the valuation and the underperformance would suggest that the returns are going to be outsized from here, maybe downsizing it after two or three good years. 

Then, of course, the UK is obviously a cheaper market than other markets, such as the US. We think the UK should be part of it, but we're obviously inclined to say that. Currently, we're probably seeing a once-in-10-year opportunity, particularly as the run up has been twice as bad as the same period leading to the GFC.

WB: What sort of common misconceptions do you think people have about small caps and the approach you generally take to investing?
Penny: People are often very backward looking. So, in so far as small companies are cyclical, and we see this with professional investors, as well as high net worths and sophisticated investors – they will look at a three-year track record. When investments are cyclical at the bottom, you will see three years of underperformance, particularly currently in the UK, where we’ve had about three and a half years of the worst we've ever seen. But of course, at that point you get cyclical lows, and it's hugely predictive for future returns, so you must look forward rather than look back.

WB: How, if at all, does the macroeconomic environment affect your views, and if so, can you illustrate that? 
Penny: It's one thing to highlight what price performance has been and link it to the economy having been difficult. The skill here is not just to say this, but to see what's going on in the economy. In that regard, the fact that the precursor to disappointing small-cap performance was interest rates going up, it therefore follows that it is very interesting to see that they're now coming down. Which has coincided with the beginnings of a pickup in sentiment and pricing, across the UK market, and to some extent in the small cap-market as well.

WB: What sort of metrics do you use in analysing small caps, and what qualitative approaches do you adopt as well? 
Penny: We are probably more price oriented than most. Through eight out of 10 years of the economic cycle, we use cash-based metrics: price to earnings ratios, free cash flow yields at the bottom of the cycle. And close to the bottom of the cycle, we will be using price to sales, or debt-adjusted market valuation to the sales and price to book. Quite often, a company that used to make 15 per cent returns might now be loss making at the bottom of the cycle. However, just because the business in a downturn is not making any money does not mean it's valueless. We must gauge its profit potential, looking forward again as well and looking back.

So, we'd also use price to book as well, or sometimes the invested capital for a business that has a lot of IP (intellectual property). I think it's quite instructive to think about rental property. When there are tenants, you know what your yield is, whether it's 6 per cent or 10 per cent in a difficult area. If you suddenly don't have any tenants and there's no income coming in, it doesn't mean that that property is valueless. It is similar for a manufacturing company or any other business that deploys capital to make a return. In a downturn, it can have little or no return. Obviously, there's often huge value to seeing what the potential recovery might be in those kinds of assets.

Simon McGivern
McGivern founded Oberon in November 2018 and led the acquisition of stockbroking firm M D Barnard, the firm’s first acquisition. He started his professional career at Panmure Gordon Asset Management in 1996. 

WealthBriefing asked him about this firm.

McGivern: Oberon Group is a financial boutique comprising four divisions: Investment and asset management, wealth planning, corporate advisory and broking, and private ventures. Our focus remains on building deep, lasting relationships with clients who value bespoke advice, whether they are high net worth individuals, entrepreneurial families, charities, or emerging institutions seeking a more personalised and transparent approach to wealth management.

We’re particularly proud of the strong internal confidence in our direction, as evidenced by the recent fundraising round where staff and directors subscribed for 15 per cent of the raise which I believe is a strong reflection of the positive outlook from within the company. 

Amidst the ongoing wave of consolidation in the UK wealth and broking sectors, we see a “once-in-a-cycle” opportunity. Many mainstream firms are becoming increasingly commoditised, leaving a gap for agile, relationship-driven firms like Oberon. We’ve laid robust foundations – a strong balance sheet, a unified and committed team, and a clear strategic vision – which we believe will create a powerful platform for growth.

The broader UK wealth sector is evolving rapidly. Clients are demanding more personalisation, transparency, and access to broader investment opportunities – from sustainable strategies to alternative assets.